Macroeconomic Challenges: The Decade Ahead– An Introduction to the 2010 Economic Policy Symposium Craig S. Hakkio and Edward S. Knotek II In the late spring of 2009, the world economy began to recover from the deepest global recession of the post-World War II era. In a number of countries where the housing crash and financial crisis still reverberate, particularly the United States, the pace of economic growth has been moderate in the first year of the recovery, contrast- ing with the historical relationship between the depth of recessions and strength of recoveries. As a consequence, policymakers continue to seek ways to stem the fallout from the crisis, promote a faster re- covery, and prevent a recurrence of these events. During the depths of the crisis, normal monetary policy instru- ments were pushed to their limits in some countries, giving way to unconventional policy actions that have left central banks with ex- panded balance sheets. Going forward, when and how to unwind these actions remain important topics of debate. In addition, the se- verity of the crisis has again raised questions about whether central banks should actively fight asset bubbles and, if so, the proper tools to use. Fiscal policy has also come under renewed scrutiny. In a number of countries, budget deficits have grown dramatically, partly as a result of capital injections, countercyclical stimulus and automatic xxi xxii Craig S. Hakkio and Edward S. Knotek II stabilizers. These large deficits will need to be unwound to prevent the types of sovereign debt crises that have affected the periphery of the euro zone. But even greater fiscal liabilities loom on the horizon, due to entitlement programs and an aging population. With uncertainty surrounding the near-term picture, this year’s symposium addressed not only near-term policy concerns but also the longer-term picture as well. The Federal Reserve Bank of Kansas City sponsored the symposium, “Macroeconomic Challenges: The Decade Ahead,” held in Jackson Hole, Wyoming, on Aug. 26-28, 2010. A distinguished group of policymakers, academic economists and financial market experts gathered to identify some of these im- portant challenges and present potential solutions. This introduction provides a brief overview of the symposium presentations and high- lights key themes raised during the course of the discussion. Challenges The conference began with two presentations identifying some of the short-term and longer-term challenges faced by the broad macroeconomy. In his opening remarks, Chairman Ben Bernanke summarized re- cent developments in the U.S. economic outlook, highlighting the uneven nature of the recovery. Over the last year, the moderate pace of growth had not been sufficient to reduce the unemployment rate by a substantial amount, while core inflation had remained positive but relatively low. In addition, some indicators suggested the pace of the recovery had slowed, raising uncertainty as to whether this might represent a temporary setback or a more pernicious trend. As a result, with the federal funds rate target set to a range of 0 to 25 basis points and the size of the Federal Reserve’s balance sheet stable at slightly more than $2 trillion, Chairman Bernanke described several further policy options available to the Federal Open Market Committee (FOMC), if further stimulus were deemed necessary. These options included making additional purchases of long-term securities, modifying the FOMC’s communications and reducing the interest rate on excess reserves. Chairman Bernanke noted that each of these options had both benefits and drawbacks, which would have Introduction xxiii to be weighed carefully by the FOMC. Moreover, given the head- winds facing the economy, it was not clear that central bankers alone could solve the world’s economic problems. The second presentation, and the first paper of the symposium, helped frame some of these headwinds in a larger, historical context. Carmen Reinhart and Vincent Reinhart studied the behavior of a number of macroeconomic variables in the 10-year periods preceding and following notable international crises of the past. The authors showed that macroeconomic performance tends to be poor in the 10 years following a severe crisis. Real per capita gross domestic product (GDP) growth rates were lower than in the 10 years before the crisis. Real house prices failed to return to their pre-crisis peaks. Unem- ployment remained persistently higher. And, reflecting broad-based weakness, inflation was lower. The paper did not attempt to disentangle correlation from causa- tion, but it documented one more suggestive fact. In the 10-year periods preceding crises, countries tended to experience sizable, long- lived surges in credit, while afterward, similar amounts of deleverag- ing took place over a comparable time span. This pattern suggests that the credit cycle may play a crucial role in fueling the boom and, as the cycle is reversed, in impeding the subsequent recovery. In discussing the paper, William White applauded the compi- lation and presentation of what he called the “awkward” facts. In line with a growing body of work from the International Monetary Fund (IMF), the Organization for Economic Cooperation and De- velopment (OECD), and other researchers, these results lead to the uncomfortable conclusion that deep, protracted slumps are indeed possible. Moreover, such findings present a challenge to the current generation of economic models that feature powerful self-correcting mechanisms and potent roles for stabilization policies. White also emphasized that more study is necessary on the role of the credit cycle in the buildup to and fallout from the crisis. He stressed that one needs to examine both the supply and the demand sides of the cycle, especially after the bust, which is relevant for the situation in which many countries find themselves today: Though xxiv Craig S. Hakkio and Edward S. Knotek II much effort is aimed at repairing the lending (supply) channel, this may be ineffective if the problem is actually on the demand side. Finally, he noted that OECD research shows a decline in potential output in the aftermath of crises, reinforcing the long-term negative consequences of these events. Credit also played an important role in the second symposium paper, by Lawrence Christiano, Cosmin Ilut, Roberto Motto, and Massimo Rostagno. Using 200 years of data on U.S. stock prices and inflation, the authors documented an intriguing pattern. In the stock market booms examined, inflation tended to be lower than its aver- age rate. Such a pattern was also present in Japan during the 1980s, when inflation was relatively low while the stock market boomed. This relationship poses a problem for monetary policy makers who follow a simple Taylor rule, in which interest rates are lowered in response to declines in inflation. In this case, a stock market boom, coupled with low inflation, would cause policymakers to lower inter- est rates, which in turn would amplify the boom-bust cycle. A better policy, the authors suggested, would be one in which in- terest rates rise in line with the natural rate of interest, thus help- ing to mitigate the boom-bust cycle. Unfortunately, the natural rate of interest is unobservable. But, the authors argued, credit growth could be a useful proxy in the Taylor rule. Augmenting a Taylor rule to include credit growth, rather than focusing solely on inflation, would lead to improved macroeconomic outcomes. Such a finding strengthens the case for monetary policy makers to pay more atten- tion to financial variables and not just consider macro variables, such as inflation and output, when setting interest rates. In discussing the paper, John Geanakoplos agreed that monetary policy makers should be concerned about credit growth. He couched this concern, however, in different terms. In his view, central bankers should attempt to tame asset bubbles by managing the leverage cycle as well as interest rates. The leverage cycle, he argued, has powerful, recurring effects. In normal times, it produces too much leverage and asset prices that are too high, while in crises, it produces too little leverage and asset Introduction xxv prices that are too low. During crises, uncertainty begets a desire for more collateral, which leads to deleveraging. This deleveraging in- creases the uncertainty about who will ultimately go bankrupt after defaulting, in a process that can last for an extended period. To help prevent these types of boom-bust leverage cycles, Geanakoplos advo- cated collecting and making more leverage data available to the pub- lic, regulating and restricting leverage during normal times, and— should a crisis nevertheless occur—reducing uncertainty by quickly writing down principal. An expanded role for stronger regulation in preventing asset bub- bles was also a key conclusion of the symposium paper by Charles Bean, Matthias Paustian, Adrian Penalver, and Tim Taylor. The au- thors first examined the role of monetary policy in the buildup to the crisis in the United States and United Kingdom. They found that accommodative monetary policy played a role in contributing to excess credit growth and house price inflation in both countries. But, they found, the role was relatively modest—smaller than the contributions made by the low volatility associated with the Great Moderation. This finding suggests that a policy of keeping interest rates higher than normal to “lean against the wind” in preventing as- set bubbles might be useful. The analysis suggested that using interest rates as the only policy tool to fully head off asset bubbles could require extremely high rates, posing large negative consequences for the real economy. Instead, the authors showed that if the monetary authority could also deploy macro-prudential regulatory policies to target areas where imbalanc- es were being created, these instruments could more effectively deal with the imbalances, thus allowing conventional monetary policy to focus on fluctuations in inflation and output.